Deficits, Market Discipline, and American Declinism

Libertarians, especially in the form of so-called ‘market economists’, are fond of touting the omnipotence and swift justice of ‘market discipline.’ Market discipline, they say, is what prevents individuals, governments, and businesses from being inefficient, wasteful, and even fraudulent. It is the (in)famous notion of market “self-correction” at its finest. Indeed, certain aspects of capitalist crises can themselves be understood simply as the triumph of market discipline over systemic inefficiencies and price distortions.

But economists all along the spectrum are now being forced to notice what is perhaps the greatest prolonged failure of market discipline in modern economic history: the U.S. twin budget and trade deficits. In an article in the Summer 2010 issue of New Politics I argued that the ability of the U.S. to run such large and sustained deficits has much to do with the dollar’s position in the global economy and, while market discipline has been extraordinarily slow in coming, the current situation simply cannot go on forever. The fact that the U.S. has, despite domestic political rhetoric, failed to seriously pressure China to revalue its currency is in itself a symptom of this disease, as the need for China to buy U.S. debt over the short-term is perceived to be far more important than the need to close the budget and trade deficits over the long-term. And, within the mainstream, there is increasing clamor about other currencies either displacing the U.S. dollar’s unique status or at least serving to dilute the dollar’s supremacy as the world’s key currency. One increasingly hears about the euro, renminbi, or even the IMF’s SDRs (Special Drawing Rights) as potential candidates. That this discussion is now taking place so regularly within the mainstream is also of considerable importance.

But a recent article appearing in Foreign Affairs expresses frustration at such “U.S. declinism” (i.e., speaking publicly of America’s imminent decline).[1] In it, Josef Joffe of Stanford University argues that “declinism” is a recurring theme throughout academic circles, but has always been, and will therefore always be, wrong. Those prophesizing the dethroning of the U.S. are mistaken, he writes, because “the United States remains first on any scale of power that matters — economic, military, diplomatic, or cultural — despite being embroiled in two wars and beset by the worst economic crisis since the Great Depression.”[2] This logic is eerily similar to the prevailing financial wisdom that lay at the heart of the U.S.-born financial crisis, which was essentially: The housing market is always a safe investment because housing prices never go down.

But, as the crash in the housing market so forcefully demonstrated, everything overvalued eventually does come down (for the most part); such is the nature of market discipline. And, as the U.S. has become increasingly reliant on either financing its deficit spending by selling off Treasury bills, or by allowing the Federal Reserve to simply create money out of thin air, one begins to wonder the extent to which U.S. sovereign debt and the dollar itself may be overvalued — i.e., the extent to which U.S. government debt is, and will continue to be, “supersafe” and “risk-free.”[3] It is these very practices which have contributed to the sort of “global imbalances” that the recent G-20 summit in Toronto sought to address by pressuring the industrialized countries to slash budget deficits (in some cases by half) by 2013.[4]

The Recurring Divide

Predictably, when talking about deficits, people often fall into the classic divide: cut the deficit at all costs vs. run up the deficit in the short-term, worry about fixing it over the long-term. But there are two points to note here.

First, as I noted in my article, having this choice is in itself a luxury that few countries facing such crises have (see Greece, Spain, and Portugal, for example), and the U.S. has — in large part because of its position as the world’s key currency holder — been able to delay scaling back its excesses for decades. As economist Nouriel Roubini notes in his new book Crisis Economics, with regard to the partially foreign-financed real estate bubble in the U.S., “Indeed, had the U.S. been an emerging economy instead of the world’s sole superpower, its creditors would have pulled the plug long ago.”[5]

Second, just as deciding which component of the U.S. budget is “wasteful” is very often a political question, deciding which components to scale back is similarly political. Abiding by the voluntary commitments the U.S. made at the G-20 summit will undoubtedly involve setting off some fiery political debates. It is therefore politically much more expedient to not disturb the status quo; simply let outright waste continue (one of my favorite examples being the lending of money to cash-strapped banks at zero interest, only to watch them then invest in government debt at two or three percent interest). But, at the same time, it would be political (and economic) suicide to not intervene during a recession such as ours: GDP would contract precipitously, international investors would begin to get nervous, unemployment would skyrocket, and class war might again, after a long and hidden dormancy, rear its ugly head in the United States.

So, we instead see deficit spending. The basic logic behind some of the deficit spending is that the U.S. government must “prime the pump,” or “manage demand,” throughout the economy. The rationale is fairly straightforward: When people begin losing their jobs, they begin consuming less. When they consume less, sellers sell less and producers produce less, resulting in ever more lost jobs. Eventually, this process occurs enough so that even individuals who have not yet lost their jobs, as well as other entities within the private sector, begin curtailing consumption (i.e., increasing personal savings) out of fear and/or speculation that prices will continue to decline, thereby further reducing aggregate demand, thereby resulting in more lost jobs, and so on. This is generally understood as the cyclical nature of a recession, thus prompting calls for “counter-cyclical” economic policies (e.g., government-led stimulus measures consisting of various tax breaks, rebates, and subsidies). Often echoing economist John Maynard Keynes, modern economists such as Paul Krugman, those at the Center for Economic and Policy Research, and even Roubini himself advocate swift, smart, and sizeable stimulus packages in times of crises — and rightly so. As CEPR economist Mark Weisbrot notes, it almost boils down to “more stimulus or more unemployment,” with the latter likely to feed into the cycle described above.[6] But often, as CEPR economist Dean Baker has done,[7] the tendency is to downplay the importance of the U.S. deficit’s size (relative to GDP) by 1) emphasizing the dangers (in the form of unemployment, deflation, etc.) of not doing more to stimulate the economy, and 2) noting that during the Great Depression and WWII, the size of the deficit relative to GDP actually soared above 100 percent, which is considerably higher than it is now.

Both points are true, but the latter is considerably misleading. There are a variety of important differences between what we see now and the international economic landscape that existed during the Great Depression. First, the political climate then permitted very progressive nominal income tax rates (the highest rate, for example, topping 90 percent), which served to at least partially offset the government’s increasing war and stimulus expenditures. Second, the U.S. was on the cusp of becoming the world’s undisputed military and economic hegemon, not least because it would, before the end of the war, be the owner of the world’s key reserve currency vis-à-vis the Bretton Woods agreement. Lastly — and this is the primary concern — the profits that could be gained from massive spending projects were more readily available and foreseeable in the 1940s (consider, for example, the Marshall Plan). But now it seems as though our horizons are bleaker — i.e., the rest of the world is in a relatively better position to compete. Mainstream commentator, Fareed Zakaria, has labeled this phenomenon the “rise of the rest,” which, he argues, in itself evidences the coming of a multi-polar, “post-American world.”

In short, the outlook in 2010 is not what it was in 1945. For example, if WWII is credited with firmly pulling the U.S. out of the Great Depression, what should our strategy be in light of the fact that we entered the recession actively fighting in two wars? What about lowering interest rates? The Fed has already brought the prime rate to near zero. (And, with regard to interest rates, do we really want households and businesses to return to the days of overleveraging and/or rampant speculation? As Roubini notes, the household-debt-to-disposable-income ratio jumped to 135 percent by 2008, from 65 percent in 1981.[8]) What about lowering income taxes? Income taxes are already very low by historical standards and, if anything, will go up as cash-strapped states try to close large budget gaps. In other words, it’s as though we are decelerating in a race while pushing the accelerator pedal to the floor. The economy went into the current recession with private and public debt already at unsustainable levels, and now the public debt situation continues to worsen with no end in sight.

Transcending The Divide

Most serious economists (mainstream or otherwise) are sympathetic to the view that the U.S. should not commit the same error as the FDR administration did in 1937 (i.e., prematurely calling for a return to ‘balanced budgeting’ and ‘fiscal prudence’). Using its powers to tax and spend, they say, the federal government should continue trying to reignite the economy where the private sector is failing to do so — virtually regardless of the debt burden incurred. But the primary concern here is that such debt levels make sense only when there is a perceptible pay-off. As such, it has become reasonable to pose the question: Where, exactly, is that pay-off? To illustrate this point, it is worth quoting Weisbrot, who writes, “Most of the present deficit is a result of the recession, and will disappear as the economy returns to full employment.”[9] Here it is treated as self-evidently true that the economy will return to full employment, presumably in the near future. But in what new markets can the U.S. dominate, so much so as to dramatically revitalize the U.S. economy and domestic employment levels, if only the initial investment outlays were there? The former saviors against declinism, which came to the fore as the dot-com bubble burst in the late 1990s, were largely found in the so-called F.I.R.E sectors: Finance, Insurance, and Real Estate. Needless to say, we’ve seen that these sectors are not reliable for sustained economic growth.

This last point is especially interesting, and has more recently been receiving thoughtful analysis by thinkers on the left. The problem, they often point out, is not merely that F.I.R.E sectors are more volatile, but that they are inherently unproductive. And this, they argue, is symptomatic of the U.S. economy as a whole. In a recent article in Rethinking Marxism, Asatar Bair notes that, “Productive activity, more than half of total employment in 1949, has dwindled to about a third in 1989.”[10] Bair acknowledges that unproductive activity as a share of total employment could not realistically reach zero percent, but he does question how low it could possibly go, asking “Could there be an entire economy that performed only unproductive activity — a nation of financiers, lawyers, government officials, advertisers, realtors, and so on?”[11] In short, how big can the leech get relative to the size of the body from which it feeds?

It would be difficult to imagine Bair’s hypothetical situation actually occurring — and yet this has long been precisely the trend: a de-industrializing economy, expanding (generally low-wage) service sectors and outsourcing manufacturing sectors. Given this situation, we should begin to rethink the standard argument, illustrated succinctly by Timothy Geithner and Lawrence Summers in a Wall Street Journal op-ed concerned with the recent G20 summit: “We must demonstrate a commitment to reducing long-term deficits, but not at the price of short-term growth. Without growth now, deficits will rise further and undermine future growth.”[12]

Fine. But a larger, more unsettling question still remains: Can everything really be fixed in the long-term? In other words, is the U.S.’s long-term position in the global economy actually more favorable than it was in previous years, or even at present? Is permanent, unfettered U.S. growth and primacy in the international marketplace a foregone conclusion? Is there some proverbial goose laying golden eggs, assuring us that, if only we weather this recession, we will finally be able to again exploit it?

Many commentators have championed “green production” and/or “green technologies” as this golden goose; the potential bulwark against U.S. declinism. For, as we can see, people may be flocking to health care, civil service, military, law enforcement, and education positions, but these are not the value-producing jobs that ultimately grow a capitalist economy. They are simply more of what Bair rightly identifies as the unproductive sectors which must be financed by actual productive activity. Moreover, budget cuts will prevent many from obtaining these jobs, and further budget cuts will prevent many poorer Americans from even attending state universities to study for these positions in the first place. Developing and producing green technologies could perhaps offer a minor ‘reindustrialization’ of the U.S., conceivably resulting in cheaper energy, increased exports, and increased employment.[13] But such an enormous success would require a correspondingly enormous federal commitment (which would, consequently, likely mean larger deficits). And if the dearth of vision in the recently passed health insurance legislation is any indication, it may be foolish to count on a green economic “revolution” in the U.S. anytime soon.

Market Discipline: Capitalism Can’t Live With It; Can’t Live Without It

Despite recently appearing on the Sean Hannity show (having what could be considered a remarkably civil interview) and offering points that gel nicely with the current Republican-turned-libertarian mantra, Nouriel Roubini’s larger arguments generally echo many of those in the spirit of Hyman Minsky, an economist widely known for his work dealing with the inherent instability of capitalism (especially in the financial sector), and the classic “pro-stimulus” Keynesian camp. For example, Roubini openly states that, in the wake of the financial crisis, “between monetary policy…and fiscal policy…everything that should have been done was done, however imperfectly.”[14] But, far more interestingly, he also suggests that the “bailouts” occurred not simply because the banks themselves were illiquid or insolvent, but because the “creditworthiness of the United States was at stake.”[15] It is here that Roubini breaks from the traditional divide, explicitly noting the vulnerabilities that the U.S. faced at the onset of the crisis precisely because of its years of excessive deficit spending. Roubini even dedicates an entire chapter toward discussing the soaring budget deficit and the increasingly precarious position of the dollar, leaving the reader with the sense that the financial crisis did not set the U.S. upon on the road toward decline, but rather served to test the extent to which the U.S. (and the rest of the dollar and U.S. security-holding world) has been on that road for many decades now. The test is somehow still being administered, but it cannot and will not go on forever.

In 1933, in the midst of the Great Depression, Keynes wrote the following:

“The decadent international but individualistic capitalism, in the hands of which we found ourselves after the [First World] war, is not a success. It is not intelligent, it is not beautiful, it is not just, it is not virtuous — and it doesn’t deliver the goods. In short we dislike it, and we are beginning to despise it. But when we wonder what to put in its place, we are extremely perplexed.”[16]

Much time has passed since then, and much effort has been made by various governments to regulate and restrain the amoral, ugly capitalism that Keynes and others understandably despised. And yet the crises have not stopped. The inequities have not been solved. And, save for a handful of “developed” countries (who, it should be noted, often depend on far less equitable countries for cheap inputs — in effect using foreign exploitation to subsidize and buttress the domestic welfare state), the great majority of the world continues to find itself in the same vicious quandary as did Keynes. On the other hand, as time has passed, much theoretical and practical effort has been expended toward figuring out “what to put in its place” once and for all. This, unlike many strains of contemporary economic thought, should not be a casualty of the recent crisis, but rather a reinvigorated, socially demanded project.

So where do we currently stand? The Obama administration is increasingly running into barriers when it comes to deficit spending, apparently regardless of what the spending is dedicated toward. Unemployment benefit extensions are becoming less politically tenable by the month,[17] and traditional safety net benefits such as Medicaid are likewise suffering setbacks[18] — all while progressive tax increases remain essentially off the table, as do (presumably to Joffe’s delight) any serious reductions in military expenditures. Individual states, too, are facing serious budget shortfalls and, as in the case of New York, legislatures are quarreling to produce budgets that range somewhere between “bad” and “very bad” for their states’ most vulnerable citizens. But given the growing costs of providing medical insurance, the continuing wars in the Middle East and military activities around the world, other financial ticking time-bombs on the horizon (such as the private equity sector), and the likelihood that the U.S. will remain with high unemployment and a sluggish economy for the foreseeable future, deficit spending will almost certainly remain the weapon of choice for as long as the U.S. is permitted to dictate the rules of the game.

In sum, the long-term economic prospectus for the U.S. may look more like that of its individual states at present than of its global position in decades past. But it would be foolish to blame this or that policy, this or that administration. The problem goes back at least as far as the early 1970s, when the U.S. entered a new era of openly attempting to evade market discipline by no longer guaranteeing the convertibility of dollars into gold. But just as in the case of the recent meltdown in mortgage-backed securities, when real decline begins in the U.S., it will be historic and have far-reaching domestic and international consequences; there will, however, be little mystery as to why it occurred.

3. In Nouriel Roubini’s new book (“Crisis Economics,” coauthored by Stephen Mihm and discussed further below), he routinely describes U.S. Treasury bills/bonds as “supersafe” and “risk-free” investments.

13. It is more than fair to argue the point that actual ‘greenness’ involves substantial reductions in personal consumption, thereby creating an irreconcilable problem with consumerist and value production-based (i.e., capitalist) economics and traditional measures of growth, standards of living, etc. However legitimate, this point falls outside of the scope of this article.